A rising stock market is generally considered favorable for investors given the magnitude of significant wealth creation due to rising stock prices. However, a rising market environment has its own set of challenges, particularly in the latter stages, as expensive valuations and the possibility of market corrections lead to confusion and fear in the minds of investors.
While it’s hard to tell the direction of the market, there are some basic principles that, if followed, can help investors manage volatility in a rising market environment.
Invest for the long term and stick to asset allocation – In a bull market environment, valuations tend to be higher, which can lead to low or negative returns in the short term. In such an environment, investors should invest with a 3-5 year view and ignore short-term volatility. Therefore, they should only commit funds for the long term and avoid investing any excess they may need over the next 1-3 years.
“Furthermore, investors should not get carried away by their emotions and stick to their long-term asset allocation plan. Therefore, it is important to continue to review and rebalance the portfolio at a predetermined interval to ensure that the actual allocation is at desired levels. This will help investors continue to take profits at regular intervals and ensure adequate allocation to less risky assets like fixed income, thereby securing liquidity which will be used to increase equity allocation in the event of a market correction. says Manish Jeloka, co-head of products. & Solutions, Sanctum Wealth.
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SIP is a better alternative to lump sum for new stock allocations – When markets are rising, investors should consider making an SIP spread over 6-12 months rather than making a lump sum investment. This will allow them to take advantage of any market volatility while reducing the risk of large losses from any sudden adverse market movements.
Invest in long-term compounders with a strong business model – One of the basic principles of investing is to invest in companies with high growth potential, commercial moat and cash flow. Investing in companies with strong fundamentals will help investors outperform the markets over the long term, despite any possible short-term pain from adverse market moves.
Consider valuations while investing – While it is important to examine the fundamentals of a stock before investing, it is also important to pay the right price for companies. Large companies will always trade at a premium to the markets given higher rates of return and growth rates. While investors will always have to pay a premium to buy into large companies, one should not overpay as this will erode returns.
“As a general rule, valuations should be considered reasonable as long as the stock is trading within one standard deviation above its latest 5-year average valuation multiple. However, if the stock is trading three standard deviations above above its latest 5-year multiple, investors should wait for valuations to return to a more reasonable level before investing,” suggests Jeloka.
Avoid companies with weak business models – One of the biggest mistakes investors make is investing in companies with weak business models simply because they are cheap in terms of P/E or P/B multiples. One should therefore not invest in a company simply because it is cheap in terms of valuation, because it more often than not turns out to be a value trap.
These companies will typically have low growth rates and yield ratios, stretched balance sheets and corporate governance issues, which explains the lower valuation multiples. Investors should avoid investing in such companies at all costs as they will continue to trade at discounted multiples and are very likely to underperform the market over the long term.
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